Inflation may have eased in many countries, but its impact remains a dominant issue for voters. Elections on both sides of the Atlantic have shown that even after inflation has been tamed, the cost of living remains a top concern. This has sparked debates on whether governments should have more control over monetary policy, as they bear the brunt of the public’s discontent when prices spike. But beyond central bank actions, the standard toolkit for managing price shocks needs to evolve, particularly as the causes of inflation shift from demand-driven to supply-side factors.
Throughout Europe and the US, inflation and the high cost of living have been key drivers in political dissatisfaction. Despite central banks’ efforts to control inflation, politicians are finding themselves blamed for rising prices. In turn, some leaders, like Argentina’s President Javier Milei and former US President Donald Trump, have suggested increasing government influence over monetary policy. However, such moves risk undermining central bank independence, leading to higher long-term interest rates and greater market uncertainty.
While direct interference in monetary policy would likely backfire, governments do need to do more to address supply-side price shocks—particularly as global forces such as climate change, trade wars, and geopolitical tensions create volatility in essential sectors like energy and food. These disruptions, often dubbed “shockflation,” are different from the demand-driven inflation of the 1980s and 1990s and require new tools to manage effectively.
Relying solely on central banks to manage these shocks is both costly and politically damaging. When inflation stems from supply disruptions, like Russia’s invasion of Ukraine, interest rate hikes hit consumers at their most vulnerable—raising mortgage payments just as energy and food prices soar. This creates a disconnect between monetary and fiscal policy, where central banks are trying to cool demand while governments are spending billions to protect households from the cost-of-living crisis.
As we face a future of potentially more frequent price shocks, driven by environmental and geopolitical factors, governments must adopt smarter strategies. Here are three key rules to help manage the next wave of inflation shocks:
1. Targeted Intervention Without Distorting Markets: Governments need to balance intervention with allowing markets to signal price changes. When energy prices spiked in Europe in 2022, some countries, like France, implemented price caps on energy bills, shielding consumers from the full brunt of rising gas prices. However, this approach can exacerbate shortages by removing the incentive for households to reduce consumption. Germany took a more balanced approach with its “gas price brake,” capping prices on 80% of households’ previous year’s consumption, leaving the remainder subject to market rates. This maintained the incentive to conserve energy while limiting the inflationary impact on consumers.
2. Preventing Excessive Corporate Profiteering: In times of crisis, dominant companies often raise prices under the guise of external shocks. In 2022, more than half of the eurozone’s price increases were driven by corporate markups, while in the US, corporate profits accounted for a significant share of the inflation spike. Vice President Kamala Harris has proposed banning “price gouging,” but the deeper issue lies in the market concentration that allows it. Encouraging competition and reducing monopolistic behavior would curb the ability of companies to exploit price shocks and improve long-term productivity.
3. Avoid Policies That Add to Inflationary Pressures: Well-intentioned policies can sometimes worsen inflation. For example, Trump’s proposal to impose higher tariffs on China would reduce economic growth and increase prices, pushing inflation higher. Similarly, Harris’s plan to offer down payment assistance for first-time homebuyers risks driving up housing demand without addressing the supply shortage. To mitigate inflation, policies aimed at increasing demand should be coupled with measures to boost supply—such as Harris’s proposed $40 billion investment in homebuilding.
As we move forward, central banks and governments must work together to develop more nuanced solutions. The Covid-19 pandemic and the war in Ukraine exposed the limitations of traditional monetary policy in the face of supply-driven inflation. The lesson for policymakers is clear: to effectively manage future price shocks, we need a smarter and more coordinated approach that tackles inflation at its source.
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